Inverse Volatility Products

As 2016 winds down, many volatility traders are likely analyzing their portfolios and starting to consider adjustments for 2017.

With the upcoming inauguration of President-elect Donald Trump, the onset of the OPEC supply cuts, and some potentially impacting Federal Reserve decisions, there's plenty of impacting events on the horizon.

At present, the VIX is sitting a bit below 14 (well below the historical average of roughly 19), while equity markets seem to be setting fresh all-time highs on a daily basis.

As the VIX hasn't closed below 9.9 at any point in the last 10 years, it's hard to imagine getting extremely short volatility/premium at VIX 14 - especially against an all-time highs backdrop.

We've previously highlighted potential ideas for trading in a low VIX environment, which you can review by clicking this link.

Given all that's coming in 2017, it's hard to imagine that the VIX won't spike at some point in the next 12 months. Today's post focuses on a recent episode of Market Measures that may help you better evaluate trading opportunities whenever volatility does go back up.

The episode in question highlights inverse exchange-traded funds (ETFs) and inverse exchange-traded notes (ETNs), and in particular, those that focus on volatility.

Inverse ETFs/ETNs are built with the intention of benefiting from dropping prices in a specific asset/benchmark. Consequently, getting long an inverse ETF/ETN means that you benefit when the asset/benchmark goes down in price, which is slightly counterintuitive (i.e. getting long to be short).

One advantage of inverse ETFs/ETNs is that investors aren't required to trade them in margin accounts, which are typically necessary when investors get short a security. In these cases, the inverse ETF/ETN holds the derivatives and/or short positions, while the investor simply "invests" in the bundle.

The two inverse products introduced on Market Measures are the Short VIX Short-Term Futures ETF (SVXY) and the Daily Inverse VIX Short-Term ETN (XIV). Both of these products seek positive returns from falling market volatility (i.e. decreasing VIX).

XIV does not have listed options and SVXY options are far less liquid than those of the VIX, making comparisons (at least in terms of derivatives) difficult. However, in order to provide context and to better understand the potential of inverse volatility products, the Market Measures team found another way to evaluate their performance.

Theoretically, an investor would choose to get long SVXY and/or XIV when volatility is high (expecting a drop) - which would also be a time that volatility traders might consider selling premium in his/her portfolio or deploying a VIX position that benefits when the VIX goes lower.

Therefore, a study was designed that compared the relative performance of selling the VIX (through a short call spread) versus getting long the SVXY or XIV.

The results, as shown below, clearly indicated that the short VIX call spreads had a higher average success rate than a long position in SVYX or XIV, and also experienced less overall variability in returns:

Moreover, another backtest was deployed that compared the same three strategies, but deployed only when VIX was above 20. The results of the second study revealed improved P/L metrics for the SVXY/XIV trades as compared to the first study, but ultimately they still lagged the performance of the short call spread in the VIX.

For the best possible understanding of the data presented on the show, we recommend watching the entire episode of Market Measures focusing on inverse volatility ETFs/ETNs.

Depending on your risk profile and outlook, it’s possible that one of the three trade structures presented in this episode may fit your portfolio when volatility does finally go back up.

If you have any questions on inverse volatility products we invite you to contact us at support@tastytrade.com.

Thanks for reading!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

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